Where to Go From Here?

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Includes: SPXU, SPY, SQQQ
by: David Moenning

It is said that the stock market likes to climb a wall of worry. If that’s the case, this market is likely to head higher – and soon – because if there is one thing for certain these days it is that there is an awful lot to worry about.

Long-time readers know that I am a big believer in the idea that one must understand the big-picture environment before you can even consider plotting out a trading/investing strategy in the near-term. But for most investors, identifying the big-picture may be a bit of a challenge right now.

For example, is the current decline merely a corrective phase within the bull market that began March 10, 2009? If this is the case, then we can argue that we should see some additional upside ahead. Or, as the bears contend, will the current dance to the downside morph into a resumption of the primary downtrend that began in 2007?

Can You Say Secular Bear?

We believe that from a really big-picture perspective (we're talking about cycles that tend to last 15 years or so), this market should remain classified as a “secular bear.” As we’ve stated in the past, we believe we are in for something along the lines of what the market experienced from 1965 through 1982; i.e. a long, frustrating period of sideways movement in the stock market that contained several meaningful mini” bull and bear markets.

However, history shows that within such a secular trend, there are usually lots of opportunities to make money, especially if one can keep the cycles in perspective and play the game accordingly. In other words, one of the keys to winning at this game is to apply the appropriate strategy to the hand you've been dealt.

In short, this means that buy-and-hold is a fine strategy if (and only if) one is willing to buy when things are really ugly (think fall 2002 or winter 2008/09). Yet, we believe that a buy-and-sell strategy, where one isn’t married to any position for too terribly long, makes infinitely more sense for the vast majority of investors in the current environment.

Of “Mini” Bulls

Getting back to where we are within the current cycle, we’re of the mind that the run for the roses that started in March 2009 is most likely a “mini” bull taking place within the context of a secular bear. As such, we should recognize that trees aren’t going to grow to the sky this time around.

On that note, given that the computers at Ned Davis Research tell us the average bull market since 1900 has produced gains of +81.2% and that the S&P had popped up +79.93% through April 23, it isn’t exactly surprising that we now find ourselves smack in the middle of a meaningful corrective phase.

So, what should we expect from here? According to Bespoke Investment Group, there have been 58 corrections of -10% or more in the Standard & Poor's 500 since 1927. In 25 cases (43%), corrections that reached the -10% mark went on to become a full-fledged bear markets, while 57% stopped short of turning truly ugly.

However, Bespoke also warns us that in the 32 instances when the market has dropped as much as this one (as of June 7th the S&P had pulled back -13.7% on a closing basis and -14.68% on an intraday basis) the corrections have a distinct tendency toward continuing. According to Bespoke’s research, only seven corrections of this magnitude stopped short of the bear market definition (generally defined as a decline of -20% or more). And in the 25 instances in which the decline reached the -20% mark, the average decline of the bear move was -35.5% from top to bottom.

But before you run out and start searching for those triple-leveraged inverse ETF’s to load up on (SQQQ and SPXU may be what you’re looking for), we should keep in mind that historical averages are, well, just that – averages. Thus, we believe that it will likely be the news flow that determines the outcome of this particular bout of selling, and not some historical pattern.

From a shorter-term technical standpoint, we’ve been arguing that since the news is now well known (is there anyone in the game that doesn’t know about the PIGI’S?), we’re likely in the midst of a basing process at the present time. And while we don’t necessarily think that new highs are going to be in the cards, we are of the mind that the bulls have earned themselves a bounce right about now.

But again, before you get too excited, we need to keep in mind that there are some pretty strong headwinds blowing that will likely keep any near-term upside in check. The issues that will likely keep a lid on any joyride to the upside include: Europe’s debt mess, the jobs picture, housing, state government deficits and debt problems, the state of the consumer, and the ongoing flow of oil gushing into the Gulf.

How to Play the Game Right Now

So, how does one play what amounts to a bunch of conflicting cycles? Here’s our view:

  • Short-term: Look for either a rebound or more basing action. How the market reacts at the all-important 1105 resistance zone is probably the key “tell.”
  • Intermediate-term: We wouldn’t be surprised to see some additional rallying after the current bad-news environment passes. But, unless things improve dramatically, we’ll suggest that there is likely to be an upside ceiling at 1240. We’ll also be watching the earnings reports closely for signs that the debt mess and/or the rally in the greenback is starting to impact earnings.
  • Long-term: Expect to see a “square root sign” recovery in the economy, which will likely lead to a range-bound market for several years.

In sum, we continue to believe that investors must be flexible going forward, both in their thinking and their investing strategy. As such, it is probably best to avoid becoming overly convicted in terms of your view of the market and/or the strategies you choose. Understand that you need to use “tools, not rules” in your approach. And above all, having a plan to manage risk if and when things turn ugly is paramount going forward.

Disclosure: No positions